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K12, Inc. (NYSE:LRN)

F2Q09 Earnings Call

February 9, 2009 4:30 pm ET

Executives

Keith Haas – Vice President, Financial Planning and Investor Relations

Ron Packard – Chief Executive Officer

John Baule – Chief Operating Officer & Chief Financial Officer

Analysts

Sara Gubins – Bank of America

Kelly Flynn – Credit Suisse

Suzi Stein – Morgan Stanley

Ariel Sokol – Wedbush Morgan

Gordon [Lasik] – Robert W. Baird

Tom [Zyfang] – [Leukam]

Jeff Silber – BMO Capital Markets

Operator

Welcome ladies and gentlemen and welcome to the second quarter 2009 K12, Inc earnings conference call. (Operator Instructions) I would now like to turn the call over to Mr. Keith Haas, Senior Vice President of Finance and Investor Relations. Please proceed.

Keith Haas

Thank you. Good afternoon and welcome to the K12 second quarter fiscal year 2009 earnings conference call. Before we begin, the company would like to remind you that statements made during this conference call and that are not historical facts may be considered forward-looking statements, made pursuant to the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995.

Forward-looking statements involve risks and uncertainties that could cause actual events or results to differ materially from those expressed or implied. In addition, this conference call contains time-sensitive information that reflects management's best analysis only as of the date of this live call.

K12 does not undertake any obligation to publicly update or revise any forward-looking statements. For further information concerning issues that could materially affect financial performance related to forward-looking statements, please refer to K12's Form 10-Q filing and 10K filings filed with the SEC, on the investor relations sections of our website, www.k12.com.

In addition to disclosing results in accordance with generally accepted accounting principles in the U.S., or GAAP, we will discuss certain information that is considered non-GAAP financial information. A reconciliation of this non-GAAP financial information and most closely comparable GAAP information was included in our earnings release and is also posted on our website.

This call is open to the public and is being web cast simultaneously on our website, and will be available for replay there for 60 days.

With me on today's call are Ron Packard, founder and Chief Executive Officer and John Baule, Chief Operating Officer and Chief Financial Officer. Following our prepared remarks we will answer any questions you may have. I will now turn the call over to Ron Packard.

Ron Packard

Thank you Keith. Welcome to K12’s second quarter 2009 earnings call. It is with great pleasure that I announce our financial results and report on other significant business developments during the quarter.

Top line revenue was up over 42% from the same quarter last year hitting $77.6 million. Revenue for the first half of fiscal year 2009 was $166.2 million a 46.2% increase over the first half of fiscal year 2008. Our business continues to scale as EBITDA is growing even faster than revenue. In fact EBITDA for the quarter grew $10.5 million, an increase of more than 68% from the second quarter of last year.

For the first six months of fiscal 2009 EBITDA was $24.2 million, a 66.3% improvement as compared to the same period fiscal year 2008. These results demonstrate that market demand for K12’s high quality offerings has not diminished during these difficult economic times. We had significant increased enrollment as more students realize the value of our offerings and online education in the K-12 space becomes a more accepted mainstream option.

We recognize that current student funding levels may be reduced this year in several states and already have taken this into account in our models. I will talk more about this later.

Even with such reductions we are maintaining our guidance of $310-320 million for fiscal year 2009 revenue and $19-22 million for operating income which implies EBITDA of approximately $38-42 million.

For the first six months of fiscal year 2009 EBITDA margin increased by 170 basis points which is at the upper end of our stated goal of improving EBITDA margins by 100-200 basis points per year. If non-recurring costs are omitted EBITDA margins would be significantly higher. However, this level of EBITDA margin expansion does not tell the whole story about how our business is scaling.

K12 is investing in businesses that we believe provide tremendous value to students and school districts and will thus grow at high rates going forward. These investments further obfuscate the scaling that is actually occurring. The aforementioned gains were achieved despite the fact that K12 opened new schools in four new states this year with substantial start up costs and associated downward margin pressure.

We also opened an international school this year and we are investing in the classroom business which will generate initial expenditures with little fiscal 2009 revenue. We anticipate the new states; the international school and the classroom business will grow at higher rates this coming year and have less adverse effect on margins going forward.

This potential growth belief is grounded by the fact the international school has been expanding mid-year and we now have 60% more students than we had October 1. In addition, through aggressive management K12 is now leveraging its corporate infrastructure and is seeing revenue for non-teaching employees increasing by approximately 80% over the past three years. We expect that this metric will continue to appreciate rapidly over the coming years as K12 seeks to maintain its rapid revenue growth and scale its infrastructure.

Turning to other developments we are quite excited by the addition of Nevada high schools as well as the signing of agreements with a number of school districts in Florida for our district based virtual school programs. The addition of new programs and new states in these times is indicative of the tremendous value K12 represents to both students and tax payers. The cost on a per pupil basis that K12 receives in each state versus per pupil revenue numbers published by the U.S. Department of Education for these states shows that the PPR we receive is significantly less than the average PPR in those states.

This represents a substantial savings in education costs to tax payers. As a result we are seeing more and more districts and legislators seeking us out as the quality and value of what K12 delivers is becoming better known.

We also want to share with you several exciting events within the company that have happened within the company in the past quarter. We completed the first release of our new content management system. This system will allow K12 to do things that we could have only dreamed about seven years ago. It will also lower the cost of our course production as it built specifically to develop online courses and will be far more efficient for course offerings.

We also completed eleven courses this past quarter which will enhance the quality of our curriculum. The high quality of our offering was recognized this quarter when two schools using the K12 curriculum won the Business Week People’s Choice Award for the best high school in their respective states. We believe that we have built the best K12 online curriculum in the market and it is the reason that our largest source of new students is referrals from current customers.

With respect to student academic results which is our primary mission we are proud to report the success of students who have stayed with the program with us from kindergarten through fourth grade. This is perhaps the best measurement tool of quality because the student has taken their entire elementary education with a K12 school. In the six states where we have data fourth grade students who have been with us since kindergarten scored approximately 20 percentage points higher than the overall state average in reading and approximately 18 percentage points higher than the overall state average in math.

We believe that academic results like this combined with the tremendous value these schools represent to the tax payers will allow us to expand the number of states that permit these options. We are also pleased to report some quite spectacular data that just became available this past quarter. The science score for our classroom pilot school in the District of Columbia were released and 100% of the children were proficient.

This is rare for a school with a high level of poverty. This proficiency level included every child in the tested grade including the special needs population. 100% proficiency in this school compares with a district average of approximately 32% in 2008.

Now I would like to address how the current economic climate may directly affect K12’s business going forward.

First, our growth is driven primarily by student enrollment and we have no reason to believe that this will slow down. Many of the macro economic variables that adversely affect other industry sectors may actually be positive for enrollment growth.

Second, we believe some states will reduce their per pupil funding level for the fiscal year and we already have adjusted our numbers for this effect. Other states may follow in the 2010 school year. Until all the budgets are completed, however, we will not know the full impact for 2009 or 2010. Making these projections even more complicated is the economic stimulus package and how that may affect the state’s education funding.

We believe in preparing for the worst and are building our budget as if the stimulus package will not help although it may. As we monitor these developments we will continue to advocate the substantial savings to tax payers and the educational benefits that can be achieved with this public school option.

Regardless of what happens with funding levels it should only have a small impact on 2010 revenue because our growth and profitability are driven primarily by enrollment.

Third, these same deflationary forces have created an opportunity to reduce costs. This is especially true for a company like K12 which is growing rapidly in this type of economy. We are already seeing significant price reductions in many things we purchase. These are driven not just by scale but also by because of a shift in the supply demand balance for most goods and services.

We have already been able to negotiate reduced rates with contractors and vendors and believe this trend will continue. We are now attacking costs with the same zeal we attacked revenue growth. These costs should help mitigate any changes in per pupil funding that may occur.

Finally, the talent pool currently available is tremendous and provides us the opportunity to hire talented people. We intend to take advantage of this opportunity.

In summary, we believe K12 remains in a relatively strong position in this environment. We should be able to expand enrollment as fast or maybe even faster than we would in an ordinary environment and certainly can reduce costs more than we otherwise could. K12 has no bank debt and we do not need to access the capital markets for cash. The company will be break even or be slightly positive here when one looks at EBITDA minus capital expenditures.

In the following year we expect this metric to be significantly positive. While these times are challenging, K12 should continue on its growth trajectory. We look to the future with tremendous enthusiasm as we are able to deliver our outstanding education to significantly more children each and every year and provide the tax payers with tremendous value.

With that let me turn the mic over to John.

John Baule

Thanks Ron. I’m going to briefly walk through some of the highlights of the second quarter and then spend a bit of extra time discussing the company’s potential for operating margin expansion and free cash flow generation, two topics that investors have expressed interest in recently.

During the second quarter the business continued to grow rapidly with revenues increasing by 42.7% and operating income increasing by 80%. Operating margins expanded by 150 basis points for the quarter to 7.7% and EBITDA, which is the measure we use to manage our business internally, increased by 68% to $10.5 million with EBITDA margins expanding by 210 basis points to 13.6% in the second quarter.

The 42.7% growth in revenues was driven by average enrollment for the quarter of 55,076, a 35.4% increase over last year. You might note that while enrollments were up substantially over last year there was a slight sequential decline from Q1 to Q2 which is attributable to three factors; First, from a comparative standpoint last year’s sequential growth between Q1 and Q2 was significantly impacted by the late approval of a new school in Georgia and an expansion of the enrollment cap in Texas.

Both of these events had the effect of pushing enrollment into October, our second quarter, and accounted for almost all of the sequential increase from Q1 to Q2 of last year.

Second, during our first quarter when all schools opened we strived to maximize enrollment in all states in which we operate. When it comes to enrolling students after the school year has started, the second quarter and beyond, we have become more sophisticated and discriminating in the manner in which we allocate our marketing dollars, considering each state’s enrollment funding level and enrollment count dates to ensure that we generate a reasonable economic return.

Third, we found it more effective academically and from a teacher efficiency standpoint to have high school students enrolling in the second quarter delay their start until the beginning of the second semester in January. The impact of this on the second quarter sequential results is amplified by the higher mix of high school students as a percentage of total enrollments. High school enrollments now comprise 19.2% of total enrollment, up from 13.7% last year.

At the end of January total enrollment was 57,199. For the third quarter we expect enrollment to be up sequentially, trailing down in the fourth quarter when we stop enrolling new students.

Over the past few months we have received a number of questions related to operating margins from investors who want to understand how operating margins might grow in the future. What I thought might be helpful is to provide an overview of some of the items impacting operating margin this year and give you a sense as to how you might think about each of these items going forward.

This is not intended to be an exhaustive list of all things which impacted operating margin during the first half of the year. There are many other factors reflected in our 9.1% actual operating margin. Rather, it is meant to provide you with insight into specific items that if considered may influence your view of the company’s potential for long-term margin expansion.

For purposes of this analysis I have used the results for the first six months of fiscal year 2009, both Q1 and Q2, and calculated the margin impact relative to the first six months of fiscal year 2008.

To set the stage, in the first half of 2009 the company’s operating income was $15.2 million or 9.1% as a percentage of revenue. This operating margin of 9.1% for the first six months of 2009 compares with an operating margin of 8.2% for the first six months of fiscal 2008. Thus, actual operating margin increased by 90 basis points.

Now I would like to discuss four specifically identifiable items which impacted operating margins in the first half of 2009.

First, the expedited shipping costs Ron referred to that we incurred during the start of the fiscal year in August through October. For the first half of the year the impact of these items reduced operating margins by 130 basis points. These issues were confined to the first half of the year and thus will have less impact on the full year 2009 operating margin and will not impact future operating margin.

Second, managed school mix. The impact of a higher percentage of managed school enrollments relative to total enrollments. Managed school enrollments, where we provide complete turnkey services to schools, generate more revenue than profits measured in absolute dollars. However, they generate a lower contribution when measured as a percentage of revenues. Managed school enrollments as a percentage of total enrollments increased from 81.3% in the first half of fiscal 2008 to 85.3% in the first half of fiscal 2009. This resulted in a 160 basis point reduction in operating margin in the first six months of the year.

In thinking about this going forward, the percentage of managed school enrollment generally remains constant over the course of the school year so we would expect this item to have approximately the same impact on full year operating margins. In thinking about this over a multi-year horizon, we expect that the mix of managed enrollment as a percentage of total enrollments will continue to increase. However, the mathematics will serve to reduce the impact of this item on operating margin in the future.

Third, the high school mix. The impact of the expanding mix of high school enrollment as a percentage of total enrollments. For reasons we have discussed in previous calls, the costs associated with delivering a high school education are higher as a percentage of revenues than for kindergarten through eighth grade students. The increase of high school enrollments from 13.7% to 19.2% of total enrollments thus had a downward impact of approximately 130 basis points on operating margin in the first half of fiscal 2009.

For the remainder of 2009 the impact of high school enrollments on operating margin should remain at levels similar to the first half of the year. Looking out over a few years there are two factors to consider; first, over time through gains in scale and productivity we would expect margins between high school and K-8 to converge which would reduce the negative impact of high school enrollment on operating margin. Second, it is likely that high school enrollment will continue to increase as a percentage of total enrollments. However, as that mix continues to progress towards a theoretical norm that we would expect to be between 30-40% of total enrollment the impact on annual operating margin progression should diminish.

I want to clarify that in the cases of both high school enrollment mix and also new schools when I use the phrase negative impact I am referring to the impact on operating margin not dollar profit contribution. Both the additional high school enrollment and the new schools we have added generate a positive dollar contribution in the current fiscal year.

The fourth item, embedded within our actual operating margin are a number of investments we are making into the business. There are three specific that I want to highlight. One is our expansion into new states and the opening of new schools. This year we entered new states as well as opened up new managed schools in Utah and Minnesota and four new states. In these schools initial investment in operations and first year enrollment levels result in higher instructional costs as a percentage of revenue.

Let me reiterate, these new schools are positive contributors in terms of dollar contribution. Longer term as we add more and more new states, we are now at 21, the impact of the start up of each state upon overall operating margin should be less.

The second investment are investments to expand our business globally. This includes our international academy and our joint venture in Dubai. The third investment is the investment that Ron spoke of to utilize our curriculum and methodologies in brick and mortar classrooms. In combination, these three investments reduced operating margin by 200 basis points for the first half of 2009 and will continue to adversely impact operating margin for the full year. We are making these investments today despite the near-term drop in operating margin because they offer higher returns in the future.

If we take these four items as a whole, the expedited shipping costs, the impact of managed school mix, the impact of high school and the investment in new schools, international and classroom the net effect is to reduce operating margin for the first six months of the year by 620 basis points.

Next I would like to make a few comments regarding the company’s potential for free cash flow generation over time. Other than income, the biggest variables impacting the company’s generation of free cash flow are the level of capital expenditures and the amount of working capital tied up in accounts receivable and to a lesser extent inventory.

First let me talk about capital expenditures. We group our capital expenditures into three primary buckets. The first bucket includes the computers we provide to students. This year we will purchase approximately $15 million worth of computers, mostly under capital lease. Over the next few years we expect these annual expenditures to increase slightly less than enrollment growth due to price reductions.

In the second bucket is our capitalized curriculum. This year we will spend approximately $11 million on curriculum. A significant portion of these expenditures are focused on building high school courses to replace licensed courses. At the end of this year we will have built over 90% of the courses required for high school and so we expect investments in our core curriculum to decline while overall investment in curriculum will remain flat in dollar terms as we identify new opportunities to leverage our curriculum development capabilities.

The third bucket of capital expenditures includes expenditures for the internal systems we require to operate our schools. For example our student management system as well as the normal property, plant and equipment associated with any business; computers, lease holder improvements, etc.

This year we will spend approximately $15 million on these types of expenditures and we expect this bucket to grow at minimal rates between zero and 10%. Overall we anticipate growth in capital expenditures of approximately 10-15% next year barring any high return opportunities for capital deployment that may arise.

The most significant component of working capital is accounts receivable. RAR largely consists of billings for the virtual public schools we serve. These schools like all other public schools including the traditional brick and mortar schools receive funding from their states based upon enrollment levels. The company is ultimately paid by the schools from these funds. The good news is that since the revenues of the schools we serve are ultimately from state governments we are highly confident that we will be paid. We have never had any school related bad debt.

On the other hand, like any public schools, we are subject to the payment terms established by the state. The level of RAR is subject to a number of factors including the funding formula used by each state and the relative mix of states as well as the number of new schools which may require cash advances to cover school start up costs. Historically we have been able to maintain DSO levels in the 70 to 90 day range with the lowest level of AR occurring in June at the end of each fiscal year.

We anticipate that we will be able to continue to maintain DSO within this range in the future although this is dependent upon the level of revenue growth and the number and size of new states we may enter. Incidentally, you may note that DSO at the end of December is slightly over 90 days. This is largely due to the temporary impact of new states and some timing of payment issues. We expect that DSO will revert back to the normal range over the next two quarters.

To a lesser extent, inventory is a significant component of working capital. The company tends to have the highest inventory levels at the end of the fiscal year as we stock up for the upcoming school year. We would anticipate year-end inventory growth at approximately the rate of anticipated enrollment growth, less reductions in the cost of materials that we may be able to generate through increased purchasing leverage or other productivity initiatives.

Combining all of these elements with our long-term revenue and profit goal, we believe that we will be at or near free cash flow positive next year. After taking into account enrollment trends, anticipated investments over the second half of the year and the public school funding landscape which Ron discussed earlier we are reconfirming our previous annual guidance for revenues to be between $310-320 million, operating income to be between $19-22 million and EBITDA to fall in the range of $38-42 million.

I hope the additional information we have provided is helpful. Overall it was a successful quarter for the company from a financial perspective and we believe that we have good momentum going into the second half of the year. With that I will turn it back over to Ron.

Ron Packard

At this time we will take any questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Sara Gubins – Bank of America.

Sara Gubins – Bank of America

Just a couple of clarification questions. Thank you for providing the details about the impact for operating margin. Just to make sure I got it, John were you basically saying that only the expedited shipping costs go away in the second half but all of the other areas that you mentioned will continue to impact operating margins in the second half of the year?

John Baule

That is correct.

Sara Gubins – Bank of America

But then also the discussion around efforts to lower costs where possible, would we presumably therefore expect to see some form of benefit from that in the second half of the year or is that more 2010?

John Baule

You would see some benefit in the second half of the year but the larger part would probably come in 2010 just as you go into the next cycle it will be more powerful.

Sara Gubins – Bank of America

Is there any way to give us even a broad range of the kind of impact you are talking of in those cost savings?

John Baule

I don’t think we can give you that at this moment in time. As I said we have gone through several already to achieve some reductions but we are very optimistic we will be able to adjust our cost structure.

Sara Gubins – Bank of America

John when you mentioned you expect to be at or near free cash flow positive next year did you mean fiscal year 2009 or 2010?

John Baule

2010.

Sara Gubins – Bank of America

So presumably negative this year and then flat to positive next year?

John Baule

That is correct.

Sara Gubins – Bank of America

I know it is early given the budget cycles and the uncertainty, but can you give us any sense of what on an aggregate basis you think it might be reasonable to see in terms of lowered student funding rates across the board for 2009 and 2010? I’m just trying to get a sense of whether or not you mean negative 5% next year or flat next year in the aggregate.

Ron Packard

That is a fair question. It is very difficult to determine because there are a lot of variables in the equation. One of the biggest ones is the stimulus bill that is going through with the aid to state education funding. We follow these closely and obviously the situation with regard to state budgets over the last few months has changed significantly. Where we see the various budget bills we see funding from a lot of states flat. We see some states proposing things as much as 4-5% a year. So we see a range. For this year we believe there will be several states that will actually reduce funding. Then next year potentially more.

It is tough. Probably three months from now we will have a lot more information on that. But right now we see funding proposals out there anywhere from flat to down 5% in the various states.

Operator

The next question comes from Kelly Flynn – Credit Suisse.

Kelly Flynn – Credit Suisse

Just some follow-up on the details, John revisiting what you said about why the enrollments declined sequentially can you elaborate on what you said as points two and three? The being more prudent with your investments was the second point. Can you get into more detail on that? Then for the high school, do the same thing? I think you said you made a decision to start people in January but can you get into more detail on that and also reiterate what you said you expect enrollment to do in the third quarter?

John Baule

First of all what I meant on the part about being more sophisticated and discriminating in the way we allocate our marketing dollars, we have to look out at the different schools and every state has a different funding mechanism. I think I talked about it on the last call. For example, in some states if a student isn’t enrolled in the beginning of October then they won’t get funded for the entire year. So obviously if you are looking at adding students in year after October that wouldn’t be a state where you would necessarily want to invest your marketing dollars.

So we just carefully look at the funding levels and the mechanisms that are in states to make sure that we are being smart in the allocation of our dollars there. That is what I mean by that. In terms of the high school question that you asked basically what that is it is just better for us from an academic standpoint. In K-8 it doesn’t really matter when they start. They can start at any time during the year with no problem. But in high school when you have semesters and a more credit oriented orientation it is just better to start them at the beginning of a semester if possible. So what happens is we might get enrollments in November and December but we hold them until the beginning of January so they start fresh.

Kelly Flynn – Credit Suisse

You said 57,199?

John Baule

Yes. If I look at my enrollments in January which kind of reflect that impact among others my enrollments at the end of January were 57,199. I would expect that our third quarter enrollment will be up sequentially from our second quarter enrollment. Generally we see a little bit of tailing off in the fourth quarter because we don’t try to replace students at all because we are close to the end of the year.

Kelly Flynn – Credit Suisse

On the point about how you are allocating marketing I just don’t understand why that would result in a reduction in enrollment. I would think if you allocated it correctly some states would benefit and others wouldn’t. Why is that?

John Baule

Remember, like any school we have students withdrawing in all schools across the course of a year, right? So what can happen is we can replace those students. We can by marketing and recruiting new students and in most cases that is pretty much what happens. But in some states we may elect not to replace those students who have withdrawn and so the enrollment across the year actually declines.

Kelly Flynn – Credit Suisse

On the separate issue on the margin discussion, on the shipping costs am I correct that happened last year also and can you help us understand why that is not going to be a chronic issue in years to come?

John Baule

It was a different issue last year. The issue we had two years ago was we had underestimated the level of demand. We just underestimated the level of enrollment. So what we had to do was go out and buy a lot of extra inventory at non-economic optimal quantities. We paid more for that inventory and still had to ship more of it faster because it came in late. So that is where it was. This time we had the inventory. Our biggest challenge was getting it into the boxes and shipped on time. So it is a different problem but the same.

Ron Packard

Just to add to that we put a great deal of emphasis on that right now and are working the process and we are pretty comfortable that will not be a recurring item.

Kelly Flynn – Credit Suisse

Another question on the investments, for 2010 and beyond can you just frame out in more detail what drag you expect in those years from the new investments? I can see if you continue to invest that could also be somewhat of a chronic drive on margins.

John Baule

If you look at the new investments this year what we said is at least in the first half of the year they had about a 200 basis point reduction. Then you really have to kind of break them up. The new schools tend to be less of a drag as they become non new schools. Whether we have additional drag from new schools depends upon how many new schools we add. The positive of that is that with each new school you add you have a bigger base. Right? So we are in 21 states now so the next state doesn’t have the same impact that we used to get from a new state when we had six states. So that is one of the factors on new states. The other piece is the international investment. We are not only hoping that won’t have a negative impact on margin, we hope that is going to have a positive impact on margin down the road. We are happy with that investment.

Ron Packard

As it achieves some scale it will no longer be negative and will hopefully turn to positive territory.

John Baule

I’m not ready to say when exactly these things all happen but what I would say is that drag should be reduced over time.

Kelly Flynn – Credit Suisse

On the state funding decisions, Ron, I know you are saying that discussions continue on that front at the state level. I thought that the decisions were made kind of late in the calendar year consistent with their fiscal year turnover. Obviously the economic environment is impacting that but can you just give us a little lesson how the timing works relative to the beginning of a new fiscal year and why it is still up for grabs given that we are well into the 2009 fiscal year?

Ron Packard

I will tell you the lessons I have learned. I have people with me who have worked in public education for 30 years and they have never quite seen anything like it where states actually go in mid-year in the school cycle and actually reduce funding. I think this is an unprecedented situation that we haven’t seen before. Certainly since the 30’s with regard to the economic environment. Normally that would not be an occurrence where in the middle of a school year you would see your funding reduced anywhere. This funding reduction is not unique to us. All public schools in those states are seeing those reductions. So we are just one school out of tens of thousands that are seeing this.

So this is an unusual event. With regard to fiscal year 2009 I would not have seen it three months ago as likely to occur. I would have considered it a very unlikely event. With regard to 2010 those budget cycles are now being determined over the next 3-5 months on how schools will fund the following school year.

So we don’t know what those are but we are getting some indications at various states based on what budget bills have come out of governor’s offices and various financial committees in the various states. So they should be set for next year and barring continued worsening of the economic climate then we should have those numbers and they should be stable for the following school year.

Operator

The next question comes from Suzi Stein – Morgan Stanley.

Suzi Stein – Morgan Stanley

Can you just clarify on your per pupil funding for your 2009 guidance what you are assuming there?

John Baule

Take $310-320 and take the mid-point of that divided by…let me just calculate…roughly $5,600 per student.

Suzi Stein – Morgan Stanley

I don’t have my model open but is that mostly…

John Baule

Flat with last year.

Suzi Stein – Morgan Stanley

Flat with last year? Okay. I know you don’t really comment on this in terms of potential new states but what is your sense about the attitude of new states approving you in this kind of climate? Are you getting more interest given the economic benefit or not?

Ron Packard

I’m not sure I’d say we have more interest but I would say last year we had a very good year with regard to new states and I would say while nothing is ever certain the horizon and outlook from where I stood would be equivalent to what I saw last year. I think in some ways the incredible savings to tax payers we offer helps us. In other cases states are focused on other things. As far as right now if you asked me I would say there is no effect positive or negative on the possibility for new states at this point in time.

Suzi Stein – Morgan Stanley

In Florida could you be a little more specific about how you are doing there? If you look at where you are now versus where you were before the changes were made going to a more local strategy where are you relative to that?

Ron Packard

At this moment in time I believe we will have more enrollments in Florida next year than we had before when we were at a state strategy based on our agreements with local districts.

Operator

The next question comes from Ariel Sokol – Wedbush Morgan.

Ariel Sokol – Wedbush Morgan

The first question is with respect to your guidance for the full year fiscal 2009. Is it safe to say that Q2 was better than what you had budgeted and then the back half of the year is impacted by declining or issues with state funding?

John Baule

I would say that it was in line with our expectations. I don’t know if I would say better.

Ariel Sokol – Wedbush Morgan

With respect to elaboration thanks for the detail regarding margins. What happens if a managed school changes the relationship with K12 and becomes or enters into a vendor relationship?

John Baule

If it goes from a managed school to a non-managed school which has happened a few times it actually increases the operating margin because we don’t have as much revenue from that school because we don’t have all the services but you are basically selling them the curriculum and materials and those tend to be higher margin but lower revenue.

Ariel Sokol – Wedbush Morgan

Wouldn’t that affect you with respect to operating profit or EPS?

John Baule

The way we think about it is we want as many kids using our curriculum and the materials. If it is through a managed school or a non-managed school we don’t really think about it. We just want them to use it.

Operator

The next question comes from Gordon [Lasik] – Robert W. Baird.

Gordon [Lasik] – Robert W. Baird

A quick question on the revenue per student. I just want to make sure I understand this correctly. You said flat revenue per student for the year and it has been up 5% in the first half of 2009 so we are assuming it is down for the second half. Is that a mix issue or is that just because states are going to be cutting funding for the second half of the year?

John Baule

I kind of look at it annual to annual. Sometimes the quarters can be misleading because remember your revenue can fluctuate. For example, in the first quarter we have a lot of revenue related to materials which would tend to give you a little bit higher revenue per enrollment if you were just looking at it quarter by quarter. The way I look at it is I look at the total year and the total year average enrollment.

Gordon [Lasik] – Robert W. Baird

In the past you have indicated you expect product development costs to increase about 10% annually. Is that still a reasonable estimate? Year-to-date I think it is down 8% so would we expect a ramp up in the second half of the year?

John Baule

It is down primarily because it is like a consulting firm. When you have very clear projects that you are working on like right now with the high school courses you are able to maintain a very high level of utilization. So that tends to offset the expense. I would say that the 10% we said before is probably good guidance for the year.

Gordon [Lasik] – Robert W. Baird

Then just one final question. Can you talk about enrollment trends within your younger class levels? K-4? Have you seen any increased drop outs there as parents are maybe forced to go back to work given the economic downturn?

Ron Packard

No. I would say we have not seen that and I think that is kind of pulling out an isolated stat in the sense that we know that there is a higher propensity to do this when you actually have an adult at home and mathematically because of unemployment going up there are a lot more adults at home today than there were one month ago even. So we actually expect potentially a shift the other way.

Operator

The next question comes from Tom [Zyfang] – [Leukam].

Tom [Zyfang] – [Leukam]

Going into the shipping costs, if it was up over $2 million and just doing simple math on revenue times market increase is it safe to assume that all else being equal you might actually get a benefit going forward given what is going on in shipping, i.e. truck load and Fedex of the world all have excess capacity?

Ron Packard

Possibly next year but this year remember that the bulk of our materials get shipped in the first quarter of our year.

Tom [Zyfang] – [Leukam]

I’m saying on calendar 2009.

John Baule

Obviously as those prices go down we would benefit from that.

Tom [Zyfang] – [Leukam]

Can you tell me what your absolute dollar was associated with shipping?

John Baule

It was $2.2 million in expedited shipping.

Ron Packard

The incremental amount is what we expected which had the 130 basis point impact was $2.2 million.

Tom [Zyfang] – [Leukam]

On what type of number? In other words what was your total shipping cost?

John Baule

I think we don’t disclose that.

Tom [Zyfang] – [Leukam]

Have there been any changes in caps? State caps we are not aware of?

Ron Packard

Not at this moment in time. We should have more clarity on that in the next quarter.

Operator

The next question comes from Jeff Silber – BMO Capital Markets.

Jeff Silber – BMO Capital Markets

I hate to go back to the funding environment but I am going to. Are you seeing any different types of conversations between the states you are already in and the states you are targeting and where I am going with this are you finding the states you are already in being a little bit more receptive on the funding side since you already had experience with them? They can see the cost benefits, etc.

Ron Packard

No I wouldn’t necessarily say that because I think now that we operate in a lot of states it is easy to present to new states what the cost benefits are and we can talk about what the price of delivering this is versus what their funding is on a per child basis. So I don’t think that is necessarily true.

Jeff Silber – BMO Capital Markets

How about on the competitive side, again going against your competitors for some of these contracts? Are you seeing some of your competitors maybe being a little bit more price sensitive, low balling, etc.?

Ron Packard

Because the pricing and the funding level is generally determined formulaically it doesn’t set itself up for that kind of environment. It is really this is what you get paid on a per child attendance basis just like brick and mortar schools get paid on a formula basis. So they don’t compete. It is the same thing here. This is what the funding level is. It is a huge discount to what the average per pupil funding is and then who can provide the best product and services for our customers in the district. So I think right now the competition is much more on quality because of the formulaic funding of it.

Operator

Ladies and gentlemen I show no further questions at this time. I would like to turn the call back over to management for any closing remarks.

Ron Packard

Thanks everybody. I want to also let everyone know we will be presenting at Deutsche Bank Small and Mid Cap Growth Conference on February 11 in Florida. Thank you.

Operator

Ladies and gentlemen thank you for your participation in today’s conference. That does conclude the presentation. You may disconnect. Have a wonderful day.

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